BUFN 722

1. BUFN 722 ch-02 Depository Institutions BUFN722- Financial Institutions

2. Overview of Depository Institutions • In this segment, we explore the depository FIs: • Size, structure and composition • Balance sheets and recent trends • Regulation of depository institutions • Depository institutions performance BUFN722- Financial Institutions

3. Products of U.S. FIs • Comparing the products of FIs in 1950, to products of FIs in 2000: • Much greater distinction between types of FIs in terms of products in 1950 than in 2000 • Blurring of product lines and services over time • Wider array of services offered by all FI types • Refer to Tables 2-1A and 2-1B in the text BUFN722- Financial Institutions

4. Size of Depository FIs • Consolidation has created some very large FIs • Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs BUFN722- Financial Institutions

5. Largest Depository Institutions, 2000 by total assets (billions) Citigroup $804.3 J.P. Morgan Chase 707.5 BankAmerica 671.7 Banc One 283.4 First Union 246.6 Wells Fargo 241.1 Washington Mutual 190.8 Fleet Boston 179.1 SunTrust Banks 100.6 HSBC 87.1 BUFN722- Financial Institutions

6. Depository Institutions • Commercial Banks • Largest depository institutions are commercial banks. • Differences in operating characteristics and profitability across size classes. • Notable differences in ROE and ROA as well as the spread • Thrifts • S&Ls • Savings Banks • Credit Unions BUFN722- Financial Institutions

7. Functions and Structural Differences • Functions of depository institutions • Regulatory sources of differences across types of depository institutions. • Structural changes generally resulted from changes in regulatory policy. • Example: changes permitting interstate branching • Reigle-Neal Act BUFN722- Financial Institutions

8. Definition of a Commercial Bank • Represent the largest group of depository institutions measured by asset size. • Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets) • Liabilities include nondeposit sources of funds such as subordinated notes and debentures • Loans are broader in range, including consumer, commercial, international, and real estate • Regulated separately from savings institutions and credit unions BUFN722- Financial Institutions

9. Differences in Balance Sheets Depository Institutions Nonfinancial Firms Assets LiabilitiesAssets Liabilities Loans Deposits Deposits Loans Other Other financial financial assets assets Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity BUFN722- Financial Institutions

10. All US Commercial Banks Balance Sheet* ($ Bil.)Federal Reserve Bulletin, May 26, 1999 Assets Total cash assets………………. $ 253.8 4.8% U.S. gov securities…………… $ 801.4 Other…………………………. 391.6 Investment securities………….. 1,193.0 22.6% Interbank loans………………. 223.0 Loans exc. Interbank………… 3,314.3 Comm. and Indust…………..$ 948.5 Real estate…………………… 1,343.0 Individual……………………. 496.4 All other……………………… 526.4 Less: Reserve for losses……… 58.7 Total loans……………………… $3,478.6 66.0% Other assets…………………….. 347.6 6.6% Total assets…………………….. $5,273.0 BUFN722- Financial Institutions

11. Commercial Bank Balance Statement* Liabilities and Equity Transaction accounts…………… $ 667.4 12.8% Nontransaction accounts………... 2,688.5 54.4% Total deposits…………………… $3,355.9 Borrowings……………………… 1,006.0 21.3% Other liabilities………………….. 462.3 2.8% Total liabilities………………….. $4,824.2 Equity…………………………… 448.8 8.7% *Aggregate balance sheet and percentage distributions for all U.S. commercial banks as of May 26, 1999 in billions of dollars BUFN722- Financial Institutions

12. Balance Sheet • Assets • loans and investment securities • Liabilities • transaction accounts - the sum of noninterest-bearing demand deposits and interest-bearing checking accounts • NOW account - an interest-bearing checking account • negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market • Equity • common and preferred stock, surplus (additional paid-in capital; paid in capital in excess of par), and retained earnings (continued) BUFN722- Financial Institutions

13. Balance Sheet • Off-Balance-Sheet activities • off-balance-sheet asset - when an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statement • off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement • Trust services • generates fees by holding and managing assets of individuals or corporations • Correspondent banking • generates fees by provision of banking services to other banks BUFN722- Financial Institutions

14. Commercial Banks • Primary assets: • Real Estate Loans: $1,670.3 billion • C&I loans: $1,048.2 billion • Loans to individuals: $609.7 billion • Other loans: $367.5 billion • Investment security portfolio: $1,662.0 billion • Of which, Treasury bonds: $710.0 billion • Inference: Importance of Credit Risk BUFN722- Financial Institutions

15. Commercial Banks • Primary liabilities: • Deposits: $4,176.6 billion • Borrowings: $1,532.5 billion • Other liabilities: $401.0 billion • Inference: • Highly leveraged BUFN722- Financial Institutions

16. Small Banks, Nation BUFN722- Financial Institutions

17. Large Banks, Nation BUFN722- Financial Institutions

18. Structure and Composition • Shrinking number of banks: • 14,416 commercial banks in 1985 • 12,744 in 1989 • 8,315 in 2000 • Mostly the result of Mergers and Acquisitions • M&A prevented prior to 1980s, 1990s • Consolidation has reduced asset share of small banks BUFN722- Financial Institutions

19. Structure and Composition of Commercial Banks • Financial Services Modernization Act 1999 • Allowed full authority to enter investment banking (and insurance) • Limited powers to underwrite corporate securities have existed only since 1987 BUFN722- Financial Institutions

20. Composition of Commercial Banking Sector • Community banks • Regional and Super-regional • Access to federal funds market to finance their lending activities • Money Center banks • Bank of New York, Bank One, Bankers Trust, Citigroup, J.P. Morgan/Chase, HSBC Bank USA • declining in number BUFN722- Financial Institutions

21. Balance Sheet and Trends • Business loans have declined in importance • Offsetting increase in securities and mortgages • Increased importance of funding via commercial paper market • Securitization of mortgage loans BUFN722- Financial Institutions

22. Some Terminology • Transaction accounts • Negotiable Order of Withdrawal (NOW) accounts • Money Market Mutual Fund • Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market. BUFN722- Financial Institutions

23. Off-balance sheet activities • Heightened importance of off-balance sheet items • Large increase in derivatives positions is a major issue • Standby letters of credit • Loan commitments • When-issued securities • Loans sold BUFN722- Financial Institutions

24. Other Fee-generating Activities • Trust services • Correspondent banking • Check clearing • Foreign exchange trading • Hedging • Participation in large loan and security issuances • Payment usually in terms of noninterest bearing deposits BUFN722- Financial Institutions

25. Key Regulatory Agencies • FDIC (BIF and SAIF)- insures deposits • OCC: Primary function is to charter national banks. • Power to disapprove mergers • FRS: monetary policy, lender of last resort. • requires all banks to meet the same noninterest-bearing reserve requirements. National banks are automatically members of the FRS. State-chartered banks can elect to become members. • State bank regulators • performs for state chartered banks similar functions as the OCC does for national banks • Dual Banking System: Coexistence of nationally and state-chartered banks. BUFN722- Financial Institutions

26. Other Regulatory Issues • Importance of Bank Holding Companies is increasing. • BHCs regulated by FRS. BUFN722- Financial Institutions

27. Reserve Requirements of Depository Institutions BUFN722- Financial Institutions

28. Key Regulatory Legislation • 1927 McFadden Act: Controls branching of national banks. • 1933 Glass-Steagall: separates securities and banking activities. • 1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs. • 1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies • 1978 International Banking Act: Regulated foreign bank branches and agencies in USA BUFN722- Financial Institutions

29. Legislation (continued) • 1980 DIDMCA and 1982 DIA (Garn-St. Germain Depository Institutions Act) • Mainly deregulation acts. • Phased out Regulation Q. • 1987 Competitive Equality in Banking Act (CEBA) • Redefined bank to limit growth of nonbank banks. BUFN722- Financial Institutions

30. Legislation (continued) • 1989 FIRREA • Imposed restrictions on investment activities • Replaced FSLIC with FDIC-SAIF • Replaced FHLB with Office of Thrift Supervision • Created Resolution Trust Corporation BUFN722- Financial Institutions

31. Legislation (continued) • 1991 FDIC Improvement Act • Introduced Prompt Corrective Action • Risk-based deposit insurance premiums • Limited “too big to fail” BUFN722- Financial Institutions

32. Legislation (continued) • 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act • Permits BHCs to acquire banks in other states. • Invalidates some restrictive state laws. • Permits BHCs to convert out-of-state subsidiary banks to branches of single interstate bank. • Newly chartered branches permitted interstate if allowed by state law. BUFN722- Financial Institutions

33. 1999 Financial Services Modernization Act • Financial Services Modernization Act • Allowed banks, insurance companies, and securities firms to enter each others’ business areas • Provided for state regulation of insurance • Streamlined regulation of BHCs • Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions • Provided for national treatment of foreign banks BUFN722- Financial Institutions

34. Industry Performance • Economic expansion and falling interest rates through 1990s • Commercial banks record earnings of $71.6 billion • Downturn in early 2000s • Reduction in performance • Increased provision for loan losses • Only 6 failures in 2000 versus 206 in 1989 • Technology risks remain BUFN722- Financial Institutions

35. The Commercial Banking Industry • I. Sources of FundsA. Deposits at Commercial Banks 1. Transaction Accounts • Transaction accounts, widely known as checking accounts, facilitate monetary exchange. • Some transaction accounts pay no interest and are often called demand deposits. • Consumer accounts can pay interest. • The most visible interest-bearing accounts are negotiable orders of withdrawal (NOW). • In many cases, deposit accounts charge fees or maintenance charges. • Recently, the use of debit cards at automated teller machines (ATMs) has given consumers greater flexibility. • Debit cards are used to make purchases via point of sale terminals (POS).

36. 2. Savings and Time Accounts • Called non-transaction deposits or time deposits, these accounts are a major source of funds. • Savings accounts allow deposits and withdrawals at any time without invoking a penalty. • Money market accounts generally offer higher yields while requiring higher balances. They were created to compete with market instruments but yields are lower and slow to adjust. • Certificates of deposit are more restrictive. They are designed to be held to maturity and carry a fixed rate of interest. • All of these accounts are backed by federal guarantees that indemnify investors in the case of loss up to $100,000. BUFN722- Financial Institutions

37. B. Non-deposit Liabilities • Banks issue a variety of debt obligations. These are not covered by federal deposit insurance but provide large amounts of cash quickly and of the desired maturity. • Banks may borrow from their holding companies in addition to the following methods of raising funds: • Federal Funds • Security Repurchase Agreements (REPOS) • Floating Rate Notes • Commercial Paper BUFN722- Financial Institutions

38. C. Equity Capital • Equity capital can be raised through the issuance of common or preferred stock. • A bank also has retained earnings. • Hybrid financial obligations have the characteristics of both equity and debt: • Variable Rate Preferred Stock • Subordinated Debt • Perpetual Floaters • II. Uses of Funds • What distinguishes a bank is the manner in which it raises funds and • deploys them. BUFN722- Financial Institutions

39. A. Cash and Cash Equivalents • Banks retain some of their resources in highly liquid form. Vault cash is used for day-to-day contingencies. Funds are maintained in a clearing account at the Fed. Bank regulators determine minimum levels of the preceding resources, referred to as required reserves. Unforeseen events lead to the maintenance of excess reserves. Checks and drafts issued on other banks are cash in the process of collection. Banks also hold CDs of other institutions. BUFN722- Financial Institutions

40. B. Investment Securities • Under current regulations, commercial banks were prohibited from holding non-financial corporate securities. Bank portfolios consist largely of government issues. Why hold these when they pay generally lower rates? • The bank may wish to “play the yield curve.” • The government may be enticed into further business. • Liquidity may be needed. • State and local securities may offer higher yields due to creditworthiness or tax considerations. • Government securities serve as temporary investments until more profitable ones arrive. • Portfolio duration can be adjusted quickly through their use. BUFN722- Financial Institutions

41. C. Loans • Banks have superior information about their clients. This natural advantage can be used in making loans. • Many loans are secured by real estate. Mortgages account for 25% of the total assets of the banking industry. • Unsecured open-ended consumer debt is known as credit card receivables. • Commercial and industrial loans are also a large component of commercial bank portfolios. • D. Tangible Property • Commercial banks also own real property such as buildings, furniture, etc. BUFN722- Financial Institutions

42. III. Beyond the Bank Balance Sheet • Competition has narrowed the spread between the cost of funds and return on investments. Banks have therefore branched out into various services that are “off balance sheet” activities. • A. Banking Services through Subsidiaries • Activities include mortgage banking, consumer lending, leasing, real estate appraisal, and credit insurance. • B. Investment Management Services • Through their trust and investment departments, banks manage billions of dollars of corporate securities. They also operate mutual funds, money market funds, and other investment companies. BUFN722- Financial Institutions

43. C. Advisory Services • Advisory services include: economic analysis, investment and financial advising, bankruptcy counseling, real estate appraisal, and bookkeeping and data processing services. • D. Brokerage Services • Bank or holding company subsidiaries offer stock and bond brokerage services. • Credit insurance on loans is often offered. Other types may be offered in the future as the new regulations are implemented. • E. Underwriting • Historically, commercial banks had been restricted from the underwriting of debt and equity. This prohibition has changed with the Financial Modernization Act of 1999. BUFN722- Financial Institutions

44. IV. Profitability of Commercial Banking • Performance of the commercial banking industry is frequently measured by the return on assets and return on equity. • As the exhibits reveal, average return has been rather low over the last fifty years. • Recently, however, commercial banks are doing well. This has been fueled by a good economy and the movement towards off-balance sheet services. BUFN722- Financial Institutions

45. Three Categories of Thrift Institutions: Overview • Savings Associations • concentrated primarily on residential mortgages • Savings Banks • large concentration of residential mortgages • commercial loans • corporate bonds • corporate stock • Credit Unions • consumer loans funded with member deposits BUFN722- Financial Institutions

46. Savings Institutions • Comprised of: • Savings Associations • Formerly known as S&L (Savings & Loans) • Savings Banks • Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q (eliminated in 1986) and disintermediation. • Effects of moral hazard and regulator forbearance. • Qualified Thrift Lender (QTL) test. BUFN722- Financial Institutions

47. Savings Institutions: Recent Trends • Industry is smaller overall • Intense competition from other FIs • mortgages for example • Concern for future viability BUFN722- Financial Institutions

48. Primary Regulators • Office of Thrift Supervision (OTS). • Charters and examines all federal S&Ls. • FDIC-SAIF Fund. • Oversees and manages Savings Association Insurance Fund (SAIF). BUFN722- Financial Institutions

49. Regulator forbearance - a policy of the FSLIC not to close economically insolvent FIs, allowing them to continue in operation • Savings institutions - savings association and savings banks combined • Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 - abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of the FDIC • QTL test- qualified thrift lender test that sets a floor on the mortgage-related assets that thrifts can hold • Mutual organization - an institution in which the liability holders are also the owners • Other S&Ls are stock held BUFN722- Financial Institutions

50. Savings Banks • Mutual organizations • Primarily East Coast • Not exposed to the oil-based shocks of 1980s • Real estate price exposure • Demutualization • Since 1989, deposits insured by BIF • May be regulated at both state and federal level BUFN722- Financial Institutions